What is TerraUSD (UST) and how does it affect Bitcoin?

Pedestrians walk past a display of cryptocurrency bitcoin on February 15, 2022 in Hong Kong, China.

Anthony Kwan | Getty Images

A multi-billion dollar bet that bitcoin could serve as a “reserve currency” for the crypto economy is already being tested as UST, a controversial stablecoin, struggles to maintain its peg to the dollar.

UST fell nearly 99 cents over the weekend, raising fears of a potential “bank run” that could force Terra, the project behind it, to plunge into a $3.5 billion bitcoin pile to prop up the token.

Now, the Luna Foundation Guard, an organization set up by the inventor of Terra, says it will lend $750 million in bitcoin to commercial companies to maintain the peg to the price of ground-based treasuries. But this did little to allay investor concerns about the implications for bitcoin.

What is a ground tank?

Developed by Terraform Labs in Singapore, UST is what is known as an algorithmic stablecoin. It aims to implement the functionality of a stablecoin like Tether, which tracks the price of the US dollar, but without any actual cash held in reserve to back it up.

Instead, the UST — or “terraUSD” — is created by destroying a sister token, known as Luna, using smart contracts, and lines of code written into the blockchain.

“If you have, say, $405, and you burn one color, you should be able to mint 405 UST stablecoins,” explains Carol Alexander, Professor of Finance at the University of Sussex.

The same is true for the other way around – the new Luna coin is minted by burning earth treasuries and other algorithmic stablecoins powered by Terra.

Terra protocols also feature an arbitrage mechanism, whereby investors can exploit the skewed prices of each of the tokens. For example, excessive demand for floor cabinets may drive their price up to $1. This means that traders can transfer 1 dollar worth of luna to the floor cabinets, and pocket the difference as profits.

The model is designed to balance supply and demand for floor tanks. When the price of floor lockers is too high, users are incentivized to burn luna and create new floor lockers, increasing the supply of stablecoins while decreasing the amount of luna in circulation.

“Luna becomes rarer, which makes it more valuable, and transfers that value to floor cabinets,” Alexander says.

When the price of the floor tanks is too low, the opposite happens – the floor tanks are burned and Luna is minted. This should, in theory, help stabilize prices.

the problem

“This assumes normal market conditions,” said David Moreno-Darukas, Research Analyst at CryptoCompare.

“During periods of high volatility and unilateral buying/selling activity of floor tanks, the above stabilizing factor may not be sufficient to sustain the peg in the short term.”

There have been many cases where terrestrial treasuries have broken with its price peg to the dollar, which has raised concerns about the viability of its economic model – particularly in a situation where many people are trying to redeem their tokens simultaneously.

The final challenge arrived over the weekend. Hundreds of millions of terrestrial treasuries have been sold on Terra’s main lending platform, Anchor, as well as Curve and Binance, leading to accusations of a “coordinated attack” on the stablecoin.

“Men will literally attack a stablecoin without success instead of going to therapy,” Do Kwon, a South Korean crypto entrepreneur who co-founded Terraform Labs, said in a since-deleted tweet.

‘reserve currency’

To address concerns about the sustainability of its stablecoin, Kwon plans to buy up to $10 billion in bitcoin through a non-profit called Luna Foundation Guard. These funds will provide a support in the event of a significant decrease in the value of the floor tanks.

The idea is that Bitcoin will act as the “reserve currency” for the Terra ecosystem.

LFG bought another $1.5 billion worth of bitcoin last week, bringing its total reserves to about $3.5 billion. However, the organization said on Monday it was taking steps to “proactively defend the stability” of the terrestrial reservoirs.

This includes lending $750 million worth of bitcoin to trading firms to “protect the interconnection of terrestrial treasuries” and lending an additional $750 million of terrestrial treasuries to purchase more bitcoin “as market conditions return to normal.”

said Vijay Ayar, Head of Corporate and International Development at crypto exchange Luno.

What does this mean for bitcoin?

Investors are concerned that UST’s bitcoin foundation will lead to more pain for the cryptocurrency.

The world’s largest digital currency fell below $33,000 on Monday, falling to its lowest level since July 2021. It was last traded at around $32,921, down 6% in the past 24 hours.

Derek Lim, head of crypto insights at exchange Bybit, said LFG’s intervention “will increase selling pressure.” “BTC will likely drop before rebounding as short sellers take profits.”

Kwon insisted that LFG “is not trying to break out of its bitcoin position.”

“As the markets recover, we plan to redeem the loan to us in BTC, which will increase the size of our total reserves,” he said.

The plan is ultimately to allow holders of terrestrial treasuries to redeem their tokens for bitcoins. Bitcoin will play the role normally played by Luna in a crisis scenario, where arbitrageurs buy floor treasuries and then exchange them for discounted Bitcoin. But we still have weeks of implementation left, and it’s unclear how it will actually work.

Hendo Verbeek, Head of Quantitative Trading Operations at the Faculty Group, said that the biggest risk going forward would be to de-pegging floor treasuries again, forcing LFG to liquidate its bitcoin holdings. This, in turn, could lead to further liquidation of “excessively leveraged” buyers, according to Verbeek.

“This is a nightmare scenario that looks like a real outcome of events,” he said.

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